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Energy Policy “Carrots and Sticks”: Bernard Chabot’s Profitability Index Method for Feed-in Tariffs July 19, 2010

Posted by Michael Hoexter in Energy Policy, Renewable Energy, Sustainable Thinking.
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Often policymakers are “flying blind” with regard to how they will incentivize or disincentivize various market and other social activities via policy design.  Part of this has to do with the complex network of stakeholders that are always involved in the design of policy as well as mismatches between the influence of one or two powerful incumbent stakeholders and the less powerful.  Another factor is that policymakers often need to rely on a disorganized web of economic opinions about how the economy works and how policy works, over which they themselves do not have clear oversight.

Bernard Chabot, a mild-mannered renewable energy engineer from France with extensive business and policy experience, has designed a system that may very well make it easier for policymakers to design policies that work according to public intentions.  Last week at the national offices of the Sierra Club, I was able to attend Chabot’s Workshop on Feed in Tariff design sponsored by the Kern-Kaweah Chapter of the Sierra Club, organized by the leading North American feed-in tariff advocate Paul Gipe.  The workshop was attended mostly by feed-in tariff and renewable energy advocates from the western US.  Besides over 25 years working in the field of renewable energy and energy efficiency, Chabot has consulted in the design of the Ontario and the French feed-in tariffs so brings to the workshop a good deal of authority with regard to the technical, policy, and business aspects.

Chabot bases his method on a much overlooked tool from corporate finance and business economics, the Profitability Index.  The Profitability Index (PI) is a number that is arrived at by dividing the present value (PV) of an investment by the total capital cost of the investment (I).  Chabot alters this slightly by using NPV in the numerator, which means Chabot’s PI uses 0 as the “break even point” like NPV rather than 1 like the traditional Profitability Index.  As NPV is much more widely used than PV as a decision tool, Chabot’s alteration can be considered justified.  What emerges are a range of values that usually range between 1 and -1.  Chabot explains how PI can be used as a universal value for understanding the profitability of various economic and even more broadly social activities and makes an argument that businesses and financiers more generally should use PI over other business measures of return on investment.  Chabot has some fairly convincing arguments that using the more popular internal rate of return (IRR) statistic leads to some misleading results and unforeseen variations in how at least renewable energy policy turns out for different market actors.

In terms of policy “carrots and sticks”, Chabot observes that policymakers should make highly desirable activities more profitable than less desirable activities by using the profitability index as a guide.  In manufacturing, a profitability index of 0.3 is minimal but in project development or construction with no R&D costs, such a PI would be highly incentivizing.  On the other hand, harmful activities should be made less profitable by the imposition of taxes or the removal of tax subsidies, pushing their profitability towards zero or below.

Turning to feed-in tariffs, Chabot uses PI as the basis for developing incentive policies which enable policymakers to keep profitability levels at acceptable but not excessive levels for project developers and facility owners.   As above, given the relatively low risk involved in a well-designed FiT, Chabot believes the PI should range between 0.1 and 0.3 for both simple “flat” FiTs and Advanced Renewable Tariffs.   Chabot believes some of the policy missteps in FiT design in certain areas could have been avoided if policymakers had used the PI method.

While FiTs are considered by almost all observers of the renewable energy scene to be the policy of choice, some simple FiTs have run into problems with either excessive profitability and an overheated market, which has attracted disproportionate attention by opponents of FiTs, or with insufficient profitability for certain types of projects.  Chabot proposes the Advanced Renewable Tariff (ART) as means for designing tariffs for wind or for regions with wide variability in the strength of renewable resources.  A single flat tariff for solar in California for instance, would make projects in southern and eastern California extremely profitable relative to projects along the foggy coast.  Similar variation can be found in many US states.  Wind resources vary widely by location as well.  The two-tier ART consists of two tariff levels with an initial higher tariff followed after a period of years by a lower tariff;  those areas with a lower resource strength will continue at the higher tariff level longer in order to enable most reasonably well designed projects in areas with adequate resource to achieve minimal profitability.  ARTs can be designed any number of ways but Chabot believes that the policy should reward utilization of the best resource areas with higher but not excessive profitability yet not overbuild solar or wind in areas with poorer resource base.

Chabot feels that ARTs are a critical instrument for a vast country like the US with multiple climate zones to be able to create policies that will spur investment in renewable energy.  Similarly countries like Italy, France and Spain with multiple climatic zones would benefit from ARTs.

In any case, I highly recommend that policymakers who are considering any number of different policy instruments that depend on incentivizing or disincentivizing various economic activities consult with Chabot and learn about his method.   While I have only experienced his one-day workshop on pricing feed-in tariffs, Chabot says that his longer workshop deals with energy efficiency as well, which similarly involves cash flows and is amenable to the profitability index. His resume and information can be found here.

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